359. In general, the measure of an equity exposure on which capital requirements is based is the value presented in the financial statements, which depending on national accounting and regulatory practices may include unrealised revaluation gains.

Thus, for example, equity exposure measures will be:

• For investments held at fair value with changes in value flowing directly through income and into regulatory capital, exposure is equal to the fair value presented in the balance sheet.

• For investments held at fair value with changes in value not flowing through income but into a tax-adjusted separate component of equity, exposure is equal to the fair value presented in the balance sheet.

• For investments held at cost or at the lower of cost or market, exposure is equal to the cost or market value presented in the balance sheet. *

* This does not affect the existing allowance of 45% of unrealised gains to Tier 2 capital in the 1988 Accord

360. Holdings in funds containing both equity investments and other non-equity types of investments can be either treated, in a consistent manner, as a single investment based on the majority of the fund’s holdings or, where possible, as separate and distinct investments in the fund’s component holdings based on a look-through approach.

361. Where only the investment mandate of the fund is known, the fund can still be treated as a single investment.

For this purpose, it is assumed that the fund first invests, to the maximum extent allowed under its mandate, in the asset classes attracting the highest capital requirement, and then continues making investments in descending order until the
maximum total investment level is reached.

The same approach can also be used for the look-through approach, but only where the bank has rated all the potential constituents of such a fund.

F. Rules for Purchased Receivables

362. Section F presents the method of calculating the UL capital requirements for purchased receivables.

For such assets, there are IRB capital charges for both default risk and dilution risk. Section III.F.1 discusses the calculation of risk-weighted assets for default risk.

The calculation of risk-weighted assets for dilution risk is provided in Section III.F.2.

The method of calculating expected losses, and for determining the difference between that measure and provisions, is described in Section III.G.

1. Risk-weighted assets for default risk

363. For receivables belonging unambiguously to one asset class, the IRB risk weight for default risk is based on the risk-weight function applicable to that particular exposure type, as long as the bank can meet the qualification standards for this particular risk-weight function.

For example, if banks cannot comply with the standards for qualifying revolving retail exposures (defined in paragraph 234), they should use the risk-weight function for other retail exposures.

For hybrid pools containing mixtures of exposure types, if the purchasing bank cannot separate the exposures by type, the risk-weight function producing the highest capital requirements for the exposure types in the receivable pool applies.

(i) Purchased retail receivables

364. For purchased retail receivables, a bank must meet the risk quantification standards for retail exposures but can utilise external and internal reference data to estimate the PDs and LGDs.

The estimates for PD and LGD (or EL) must be calculated for the receivables on a stand-alone basis; that is, without regard to any assumption of recourse or guarantees from the seller or other parties.

(ii) Purchased corporate receivables

365. For purchased corporate receivables the purchasing bank is expected to apply the existing IRB risk quantification standards for the bottom-up approach.

However, for eligible purchased corporate receivables, and subject to supervisory permission, a bank may employ
the following top-down procedure for calculating IRB risk weights for default risk:

• The purchasing bank will estimate the pool’s one-year EL for default risk, expressed in percentage of the exposure amount (i.e. the total EAD amount to the bank by all obligors in the receivables pool).

The estimated EL must be calculated for the receivables on a stand-alone basis; that is, without regard to any assumption of
recourse or guarantees from the seller or other parties.

The treatment of recourse or guarantees covering default risk (and/or dilution risk) is discussed separately below.

• Given the EL estimate for the pool’s default losses, the risk weight for default risk is determined by the risk-weight function for corporate exposures. *

As described below, the precise calculation of risk weights for default risk depends on the bank’s ability to decompose EL into its PD and LGD components in a reliable manner.

Banks can utilise external and internal data to estimate PDs and LGDs.

However, the advanced approach will not be available for banks that use the foundation approach for corporate exposures.

* The firm-size adjustment for SME, as defined in paragraph 273, will be the weighted average by individual exposure of the pool of purchased corporate receivables. If the bank does not have the information to calculate the average size of the pool, the firm-size adjustment will not apply.

Foundation IRB treatment

366. If the purchasing bank is unable to decompose EL into its PD and LGD components in a reliable manner, the risk weight is determined from the corporate risk-weight function using the following specifications: if the bank can demonstrate that the exposures are exclusively senior claims to corporate borrowers, an LGD of 45% can be used.

PD will be calculated by dividing the EL using this LGD. EAD will be calculated as the outstanding amount minus the capital charge for dilution prior to credit risk mitigation (KDilution).

Otherwise, PD is the bank’s estimate of EL; LGD will be 100%; and EAD is the amount outstanding minus KDilution. EAD for a revolving purchase facility is the sum of the current amount of receivables purchased plus 75% of any undrawn purchase commitments minus KDilution.

If the purchasing bank is able to estimate PD in a reliable manner, the risk weight is determined from the corporate risk-weight functions according to the specifications for LGD, M and the treatment of guarantees under the foundation approach as given in paragraphs 287 to 296, 299, 300 to 305, and 318.

Advanced IRB treatment

367. If the purchasing bank can estimate either the pool’s default-weighted average loss rates given default (as defined in paragraph 468) or average PD in a reliable manner, the bank may estimate the other parameter based on an estimate of the expected long-run loss rate.

The bank may

(i) use an appropriate PD estimate to infer the long-run default-weighted average loss rate given default, or

(ii) use a long-run default-weighted average loss rate given default to infer the appropriate PD.

In either case, it is important to recognise that the LGD used for the IRB capital calculation for purchased receivables cannot be less than the long-run default-weighted average loss rate given default and must be consistent with the concepts defined in paragraph 468.

The risk weight for the purchased receivables will be determined using the bank’s estimated PD and LGD as inputs to the corporate risk-weight function.

Similar to the foundation IRB treatment, EAD will be the amount outstanding minus KDilution. EAD for a revolving purchase facility will be the sum of the current amount of receivables purchased plus 75% of any undrawn purchase commitments minus KDilution (thus, banks using the advanced IRB approach will not be permitted to use their internal EAD estimates for undrawn purchase commitments).

368. For drawn amounts, M will equal the pool’s exposure-weighted average effective maturity (as defined in paragraphs 320 to 324). This same value of M will also be used for undrawn amounts under a committed purchase facility provided the facility contains effective covenants, early amortisation triggers, or other features that protect the purchasing bank against a significant deterioration in the quality of the future receivables it is required to purchase over the facility’s term.

Absent such effective protections, the M for undrawn amounts will be calculated as the sum of

(a) the longest-dated potential receivable under the purchase agreement and

(b) the remaining maturity of the purchase facility.

2. Risk-weighted assets for dilution risk

369. Dilution refers to the possibility that the receivable amount is reduced through cash or non-cash credits to the receivable’s obligor. *

For both corporate and retail receivables, unless the bank can demonstrate to its supervisor that the dilution risk for the purchasing bank is immaterial, the treatment of dilution risk must be the following: at the level of either the pool as a whole (top-down approach) or the individual receivables making up the pool (bottom-up approach), the purchasing bank will estimate the one-year EL for dilution risk, also expressed in percentage of the receivables amount.

Banks can utilise external and internal data to estimate EL.

As with the treatments of default risk, this estimate must be computed on a stand-alone basis; that is, under the assumption of no recourse or other support from the seller or third-party guarantors.

For the purpose of calculating risk weights for dilution risk, the corporate risk-weight function must be used with the following settings: the PD must be set equal to the estimated EL, and the LGD must be set at 100%.

An appropriate maturity treatment applies when determining the capital requirement for dilution risk.

If a bank can demonstrate that the dilution risk is appropriately monitored and managed to be resolved within one year, the supervisor may allow the bank to apply a one-year maturity.

* Examples include offsets or allowances arising from returns of goods sold, disputes regarding product quality, possible debts of the borrower to a receivables obligor, and any payment or promotional discounts offered by the borrower (e.g. a credit for cash payments within 30 days).

370. This treatment will be applied regardless of whether the underlying receivables are corporate or retail exposures, and regardless of whether the risk weights for default risk are computed using the standard IRB treatments or, for corporate receivables, the top-down treatment described above.

3. Treatment of purchase price discounts for receivables

371. In many cases, the purchase price of receivables will reflect a discount (not to be confused with the discount concept defined in paragraphs 308 and 334) that provides first loss protection for default losses, dilution losses or both (see paragraph 629).

To the extent a portion of such a purchase price discount will be refunded to the seller, this refundable amount may be treated as first loss protection under the IRB securitisation framework.

Non refundable purchase price discounts for receivables do not affect either the EL-provision calculation in Section III.G or the calculation of risk-weighted assets.

372. When collateral or partial guarantees obtained on receivables provide first loss protection (collectively referred to as mitigants in this paragraph), and these mitigants cover default losses, dilution losses, or both, they may also be treated as first loss protection under the IRB securitisation framework (see paragraph 629).

When the same mitigant covers both default and dilution risk, banks using the Supervisory Formula that are able to calculate an exposure-weighted LGD must do so as defined in paragraph 634.

4. Recognition of credit risk mitigants

373. Credit risk mitigants will be recognised generally using the same type of framework as set forth in paragraphs 300 to 307.85 In particular, a guarantee provided by the seller or a third party will be treated using the existing IRB rules for guarantees, regardless of whether the guarantee covers default risk, dilution risk, or both.

• If the guarantee covers both the pool’s default risk and dilution risk, the bank will substitute the risk weight for an exposure to the guarantor in place of the pool’s total risk weight for default and dilution risk.

• If the guarantee covers only default risk or dilution risk, but not both, the bank will substitute the risk weight for an exposure to the guarantor in place of the pool’s risk weight for the corresponding risk component (default or dilution).

The capital requirement for the other component will then be added.

• If a guarantee covers only a portion of the default and/or dilution risk, the uncovered portion of the default and/or dilution risk will be treated as per the existing CRM rules for proportional or tranched coverage (i.e. the risk weights of the uncovered risk components will be added to the risk weights of the covered risk components).

373 (i). If protection against dilution risk has been purchased, and the conditions of paragraphs 307 (i) and 307 (ii) are met, the double default framework may be used for the calculation of the risk-weighted asset amount for dilution risk.  *

In this case, paragraphs 284 (i) to 284 (iii) apply with PDo being equal to the estimated EL, LGDg being equal to 100 percent,
and effective maturity being set according to paragraph 369.

* At national supervisory discretion, banks may recognise guarantors that are internally rated and associated with a PD equivalent to less than A- under the foundation IRB approach for purposes of determining capital requirements for dilution risk.

G. Treatment of Expected Losses and Recognition of Provisions

374. Section III.G discusses the method by which the difference between provisions (e.g. specific provisions, portfolio-specific general provisions such as country risk provisions or general provisions) and expected losses may be included in or must be deducted from regulatory capital, as outlined in paragraph 43.

1. Calculation of expected losses

375. A bank must sum the EL amount (defined as EL multiplied by EAD) associated with its exposures (excluding the EL amount associated with equity exposures under the PD/LGD approach and securitisation exposures) to obtain a total EL amount.

While the EL amount associated with equity exposures subject to the PD/LGD approach is excluded from the total
EL amount, paragraphs 376 and 386 apply to such exposures.

The treatment of EL for securitisation exposures is described in paragraph 563.

(i) Expected loss for exposures other than SL subject to the supervisory slotting criteria

376. Banks must calculate an EL as PD x LGD for corporate, sovereign, bank, and retail exposures both not in default and not treated as hedged exposures under the double default treatment.

For corporate, sovereign, bank, and retail exposures that are in default, banks must use their best estimate of expected loss as defined in paragraph 471 and banks on the foundation approach must use the supervisory LGD.

For SL exposures subject to the supervisory slotting criteria EL is calculated as described in paragraphs 377 and 378.

For equity exposures subject to the PD/LGD approach, the EL is calculated as PD x LGD unless paragraphs 351 to 354 apply. Securitisation exposures do not contribute to the EL amount, as set out in paragraph 563.

For all other exposures, including hedged exposures under the double default treatment, the EL is zero.

(ii) Expected loss for SL exposures subject to the supervisory slotting criteria

377. For SL exposures subject to the supervisory slotting criteria, the EL amount is determined by multiplying 8% by the risk-weighted assets produced from the appropriate risk weights, as specified below, multiplied by EAD.

Supervisory categories and EL risk weights for other SL exposures

378. The risk weights for SL, other than HVCRE, are as follows:

Where, at national discretion, supervisors allow banks to assign preferential risk weights to other SL exposures falling into the “strong” and “good” supervisory categories as outlined in paragraph 277, the corresponding EL risk weight is 0% for “strong” exposures, and 5% for “good” exposures.

Supervisory categories and EL risk weights for HVCRE

379. The risk weights for HVCRE are as follows:

Even where, at national discretion, supervisors allow banks to assign preferential risk weights to HVCRE exposures falling into the “strong” and “good” supervisory categories as outlined in paragraph 282, the corresponding EL risk weight will remain at 5% for both “strong” and “good” exposures.

2. Calculation of provisions

(i) Exposures subject to IRB approach

380. Total eligible provisions are defined as the sum of all provisions (e.g. specific provisions, partial write-offs, portfolio-specific general provisions such as country risk provisions or general provisions) that are attributed to exposures treated under the IRB approach.

In addition, total eligible provisions may include any discounts on defaulted assets.

Specific provisions set aside against equity and securitisation exposures must not be included in total eligible provisions.

(ii) Portion of exposures subject to the standardised approach to credit risk

381. Banks using the standardised approach for a portion of their credit risk exposures, either on a transitional basis (as defined in paragraphs 257 and 258), or on a permanent basis if the exposures subject to the standardised approach are immaterial (paragraph 259), must determine the portion of general provisions attributed to the standardised or IRB
treatment of provisions (see paragraph 42) according to the methods outlined in paragraphs 382 and 383.

382. Banks should generally attribute total general provisions on a pro rata basis according to the proportion of credit risk-weighted assets subject to the standardised and IRB approaches.

However, when one approach to determining credit risk-weighted assets (i.e. standardised or IRB approach) is used exclusively within an entity, general provisions booked within the entity using the standardised approach may be attributed to the standardised treatment.

Similarly, general provisions booked within entities using the IRB approach may be attributed to the total eligible provisions as defined in paragraph 380.

383. At national supervisory discretion, banks using both the standardised and IRB approaches may rely on their internal methods for allocating general provisions for recognition in capital under either the standardised or IRB approach, subject to the following conditions.

Where the internal allocation method is made available, the national supervisor will establish the standards surrounding their use. Banks will need to obtain prior approval from their supervisors to use an internal allocation method for this purpose.

3. Treatment of EL and provisions

384. As specified in paragraph 43, banks using the IRB approach must compare the total amount of total eligible provisions (as defined in paragraph 380) with the total EL amount as calculated within the IRB approach (as defined in paragraph 375).

In addition, paragraph 42 outlines the treatment for that portion of a bank that is subject to the standardised approach
to credit risk when the bank uses both the standardised and IRB approaches.

385. Where the calculated EL amount is lower than the provisions of the bank, its supervisors must consider whether the EL fully reflects the conditions in the market in which it operates before allowing the difference to be included in Tier 2 capital.

If specific provisions exceed the EL amount on defaulted assets this assessment also needs to be made before using the difference to offset the EL amount on non-defaulted assets.

386. The EL amount for equity exposures under the PD/LGD approach is deducted 50% from Tier 1 and 50% from Tier 2.

Provisions or write-offs for equity exposures under the PD/LGD approach will not be used in the EL-provision calculation.

The treatment of EL and provisions related to securitisation exposures is outlined in paragraph 563.

H. Minimum Requirements for IRB Approach

387. Section III.H presents the minimum requirements for entry and on-going use of the IRB approach. The minimum requirements are set out in 12 separate sections concerning:

(a) composition of minimum requirements,

(b) compliance with minimum requirements,

(c) rating system design,

(d) risk rating system operations,

(e) corporate governance and oversight,

(f) use of internal ratings,

(g) risk quantification,

(h) validation of internal estimates,

(i) supervisory LGD and EAD estimates,

(j) requirements for recognition of leasing,

(k) calculation of capital charges for equity exposures, and

(l) disclosure requirements.

It may be helpful to note that the minimum requirements cut across asset classes.

Therefore, more than one asset class may be discussed within the context of a given minimum requirement.

1. Composition of minimum requirements

388. To be eligible for the IRB approach a bank must demonstrate to its supervisor that it meets certain minimum requirements at the outset and on an ongoing basis.

Many of these requirements are in the form of objectives that a qualifying bank’s risk rating systems must fulfil.

The focus is on banks’ abilities to rank order and quantify risk in a consistent, reliable and valid fashion.

389. The overarching principle behind these requirements is that rating and risk estimation systems and processes provide for a meaningful assessment of borrower and transaction characteristics; a meaningful differentiation of risk; and reasonably accurate and consistent quantitative estimates of risk.

Furthermore, the systems and processes must be consistent with internal use of these estimates.

The Committee recognises that differences in markets, rating methodologies, banking products, and practices require banks and supervisors to customise their operational procedures.

It is not the Committee’s intention to dictate the form or operational detail of banks’ risk management policies and practices.

Each supervisor will develop detailed review procedures to ensure that banks’ systems and controls are adequate to serve as the basis for the IRB approach.

390. The minimum requirements set out in this document apply to all asset classes unless noted otherwise.

The standards related to the process of assigning exposures to borrower or facility grades (and the related oversight, validation, etc.) apply equally to the process of assigning retail exposures to pools of homogenous exposures, unless noted otherwise.

391. The minimum requirements set out in this document apply to both foundation and advanced approaches unless noted otherwise.

Generally, all IRB banks must produce their own estimates of PD * and must adhere to the overall requirements for rating system design, operations, controls, and corporate governance, as well as the requisite requirements for estimation and validation of PD measures.

Banks wishing to use their own estimates of LGD and EAD must also meet the incremental minimum requirements for these risk factors included in paragraphs 468 to 489.

* Banks are not required to produce their own estimates of PD for certain equity exposures and certain exposures that fall within the SL sub-class.

2. Compliance with minimum requirements

392. To be eligible for an IRB approach, a bank must demonstrate to its supervisor that it meets the IRB requirements in this document, at the outset and on an ongoing basis.

Banks’ overall credit risk management practices must also be consistent with the evolving sound practice guidelines issued by the Committee and national supervisors.

393. There may be circumstances when a bank is not in complete compliance with all the minimum requirements.

Where this is the case, the bank must produce a plan for a timely return to compliance, and seek approval from its supervisor, or the bank must demonstrate that the effect of such non-compliance is immaterial in terms of the risk posed to the
institution.

Failure to produce an acceptable plan or satisfactorily implement the plan or to demonstrate immateriality will lead supervisors to reconsider the bank’s eligibility for the IRB approach.

Furthermore, for the duration of any non-compliance, supervisors will consider the need for the bank to hold additional capital under Pillar 2 or take other appropriate supervisory action.

3. Rating system design

394. The term “rating system” comprises all of the methods, processes, controls, and data collection and IT systems that support the assessment of credit risk, the assignment of internal risk ratings, and the quantification of default and loss estimates.

395. Within each asset class, a bank may utilise multiple rating methodologies/systems.

For example, a bank may have customised rating systems for specific industries or market segments (e.g. middle market, and large corporate).

If a bank chooses to use multiple systems, the rationale for assigning a borrower to a rating system must be documented and
applied in a manner that best reflects the level of risk of the borrower.

Banks must not allocate borrowers across rating systems inappropriately to minimise regulatory capital requirements (i.e. cherry-picking by choice of rating system).

Banks must demonstrate that each system used for IRB purposes is in compliance with the minimum requirements at the
outset and on an ongoing basis.

(i) Rating dimensions

Standards for corporate, sovereign, and bank exposures

396. A qualifying IRB rating system must have two separate and distinct dimensions:

(i) the risk of borrower default, and

(ii) transaction-specific factors.

397. The first dimension must be oriented to the risk of borrower default.

Separate exposures to the same borrower must be assigned to the same borrower grade, irrespective of any differences in the nature of each specific transaction.

There are two exceptions to this.

Firstly, in the case of country transfer risk, where a bank may assign different borrower grades depending on whether the facility is denominated in local or foreign currency.

Secondly, when the treatment of associated guarantees to a facility may be reflected in an adjusted borrower grade. In either case, separate exposures may result in multiple grades for the same borrower.

A bank must articulate in its credit policy the relationship between borrower grades in terms of the level of risk each grade implies.

Perceived and measured risk must increase as credit quality declines from one grade to the next.

The policy must articulate the risk of each grade in terms of both a description of the probability of default risk
typical for borrowers assigned the grade and the criteria used to distinguish that level of credit risk.

398. The second dimension must reflect transaction-specific factors, such as collateral, seniority, product type, etc.

For foundation IRB banks, this requirement can be fulfilled by the existence of a facility dimension, which reflects both borrower and transaction-specific factors.

For example, a rating dimension that reflects EL by incorporating both borrower strength (PD) and loss severity (LGD) considerations would qualify.

Likewise a rating system that exclusively reflects LGD would qualify.

Where a rating dimension reflects EL and does not separately quantify LGD, the supervisory estimates of LGD must be used.

399. For banks using the advanced approach, facility ratings must reflect exclusively LGD.

These ratings can reflect any and all factors that can influence LGD including, but not limited to, the type of collateral, product, industry, and purpose.

Borrower characteristics may be included as LGD rating criteria only to the extent they are predictive of LGD.

Banks may alter the factors that influence facility grades across segments of the portfolio as long as they can satisfy their supervisor that it improves the relevance and precision of their estimates.

400. Banks using the supervisory slotting criteria for the SL sub-class are exempt from this two-dimensional requirement for these exposures. Given the interdependence between borrower/transaction characteristics in SL, banks may satisfy the requirements under this heading through a single rating dimension that reflects EL by incorporating both borrower
strength (PD) and loss severity (LGD) considerations.

This exemption does not apply to banks using either the general corporate foundation or advanced approach for the SL subclass. Standards for retail exposures

401. Rating systems for retail exposures must be oriented to both borrower and transaction risk, and must capture all relevant borrower and transaction characteristics.

Banks must assign each exposure that falls within the definition of retail for IRB purposes into a particular pool. Banks must demonstrate that this process provides for a meaningful differentiation of risk, provides for a grouping of sufficiently homogenous exposures, and allows for accurate and consistent estimation of loss characteristics at pool level.

402. For each pool, banks must estimate PD, LGD, and EAD. Multiple pools may share identical PD, LGD and EAD estimates.

At a minimum, banks should consider the following risk drivers when assigning exposures to a pool:

• Borrower risk characteristics (e.g. borrower type, demographics such as age/occupation);

• Transaction risk characteristics, including product and/or collateral types (e.g. loan to value measures, seasoning, guarantees; and seniority (first vs. second lien)).

Banks must explicitly address cross-collateral provisions where present.

• Delinquency of exposure: Banks are expected to separately identify exposures that are delinquent and those that are not.

(ii) Rating structure

Standards for corporate, sovereign, and bank exposures

403. A bank must have a meaningful distribution of exposures across grades with no excessive concentrations, on both its borrower-rating and its facility-rating scales.

404. To meet this objective, a bank must have a minimum of seven borrower grades for non-defaulted borrowers and one for those that have defaulted.

Banks with lending activities focused on a particular market segment may satisfy this requirement with the minimum
number of grades; supervisors may require banks, which lend to borrowers of diverse credit quality, to have a greater number of borrower grades.

405. A borrower grade is defined as an assessment of borrower risk on the basis of a specified and distinct set of rating criteria, from which estimates of PD are derived.

The grade definition must include both a description of the degree of default risk typical for borrowers assigned the grade and the criteria used to distinguish that level of credit risk.

Furthermore, “+” or “-” modifiers to alpha or numeric grades will only qualify as distinct grades if the bank has developed complete rating descriptions and criteria for their assignment, and separately quantifies PDs for these modified grades.

406. Banks with loan portfolios concentrated in a particular market segment and range of default risk must have enough grades within that range to avoid undue concentrations of borrowers in particular grades.

Significant concentrations within a single grade or grades must be supported by convincing empirical evidence that the grade or grades cover reasonably narrow PD bands and that the default risk posed by all borrowers in a grade fall within that band.

407. There is no specific minimum number of facility grades for banks using the advanced approach for estimating LGD. A bank must have a sufficient number of facility grades to avoid grouping facilities with widely varying LGDs into a single grade.

The criteria used to define facility grades must be grounded in empirical evidence.

408. Banks using the supervisory slotting criteria for the SL asset classes must have at least four grades for non-defaulted borrowers, and one for defaulted borrowers.

The requirements for SL exposures that qualify for the corporate foundation and advanced approaches are the same as those for general corporate exposures.

Standards for retail exposures

409. For each pool identified, the bank must be able to provide quantitative measures of loss characteristics (PD, LGD, and EAD) for that pool.

The level of differentiation for IRB purposes must ensure that the number of exposures in a given pool is sufficient so as to
allow for meaningful quantification and validation of the loss characteristics at the pool level.

There must be a meaningful distribution of borrowers and exposures across pools.

A single pool must not include an undue concentration of the bank’s total retail exposure.

(iii) Rating criteria

410. A bank must have specific rating definitions, processes and criteria for assigning exposures to grades within a rating system. The rating definitions and criteria must be both plausible and intuitive and must result in a meaningful differentiation of risk.

• The grade descriptions and criteria must be sufficiently detailed to allow those charged with assigning ratings to consistently assign the same grade to borrowers or facilities posing similar risk.

This consistency should exist across lines of business, departments and geographic locations.

If rating criteria and procedures differ for different types of borrowers or facilities, the bank must monitor for possible
inconsistency, and must alter rating criteria to improve consistency when appropriate.

• Written rating definitions must be clear and detailed enough to allow third parties to understand the assignment of ratings, such as internal audit or an equally independent function and supervisors, to replicate rating assignments and evaluate
the appropriateness of the grade/pool assignments.

• The criteria must also be consistent with the bank’s internal lending standards and its policies for handling troubled borrowers and facilities.

411. To ensure that banks are consistently taking into account available information, they must use all relevant and material information in assigning ratings to borrowers and facilities.

Information must be current.

The less information a bank has, the more conservative must be its assignments of exposures to borrower and facility grades or pools.

An external rating can be the primary factor determining an internal rating assignment; however, the bank must
ensure that it considers other relevant information.

SL product lines within the corporate asset class

412. Banks using the supervisory slotting criteria for SL exposures must assign exposures to their internal rating grades based on their own criteria, systems and processes, subject to compliance with the requisite minimum requirements.

Banks must then map these internal rating grades into the five supervisory rating categories.

Tables 1 to 4 in Annex 6 provide, for each sub-class of SL exposures, the general assessment factors and characteristics exhibited by the exposures that fall under each of the supervisory categories.

Each lending activity has a unique table describing the assessment factors and characteristics.

413. The Committee recognises that the criteria that banks use to assign exposures to internal grades will not perfectly align with criteria that define the supervisory categories;

however, banks must demonstrate that their mapping process has resulted in an alignment of grades which is consistent with the preponderance of the characteristics in the respective supervisory category.

Banks should take special care to ensure that any overrides of their internal criteria do not render the mapping process ineffective.

(iv) Rating assignment horizon

414. Although the time horizon used in PD estimation is one year (as described in paragraph 447), banks are expected to use a longer time horizon in assigning ratings.

415. A borrower rating must represent the bank’s assessment of the borrower’s ability and willingness to contractually perform despite adverse economic conditions or the occurrence of unexpected events.

For example, a bank may base rating assignments on specific, appropriate stress scenarios.

Alternatively, a bank may take into account borrower characteristics that are reflective of the borrower’s vulnerability to adverse economic conditions or unexpected events, without explicitly specifying a stress scenario.

The range of economic conditions that are considered when making assessments must be consistent with current conditions and those that are likely to occur over a business cycle within the respective industry/geographic region.

416. Given the difficulties in forecasting future events and the influence they will have on a particular borrower’s financial condition, a bank must take a conservative view of projected information.

Furthermore, where limited data are available, a bank must adopt a conservative bias to its analysis.

(v) Use of models

417. The requirements in this section apply to statistical models and other mechanical methods used to assign borrower or facility ratings or in estimation of PDs, LGDs, or EADs.

Credit scoring models and other mechanical rating procedures generally use only a subset of available information. Although mechanical rating procedures may sometimes avoid some of the idiosyncratic errors made by rating systems in which human judgement plays a large role, mechanical use of limited information also is a source of rating errors.

Credit scoring models and other mechanical procedures are permissible as the primary or partial basis of rating assignments, and may play a role in the estimation of loss characteristics.

Sufficient human judgement and human oversight is necessary to ensure that all relevant and material information, including that which is outside the scope of the model, is also taken into consideration, and that the model is used appropriately.

• The burden is on the bank to satisfy its supervisor that a model or procedure has good predictive power and that regulatory capital requirements will not be distorted as a result of its use.

The variables that are input to the model must form a reasonable set of predictors.

The model must be accurate on average across the range of borrowers or facilities to which the bank is exposed and there must be no known material biases.

• The bank must have in place a process for vetting data inputs into a statistical default or loss prediction model which includes an assessment of the accuracy, completeness and appropriateness of the data specific to the assignment of an
approved rating.

• The bank must demonstrate that the data used to build the model are representative of the population of the bank’s actual borrowers or facilities.

• When combining model results with human judgement, the judgement must take into account all relevant and material information not considered by the model.

The bank must have written guidance describing how human judgement and model results are to be combined.

• The bank must have procedures for human review of model-based rating assignments.

Such procedures should focus on finding and limiting errors associated with known model weaknesses and must also include credible ongoing efforts to improve the model’s performance.

• The bank must have a regular cycle of model validation that includes monitoring of model performance and stability; review of model relationships; and testing of model outputs against outcomes.

(vi) Documentation of rating system design

418. Banks must document in writing their rating systems’ design and operational details.

The documentation must evidence banks’ compliance with the minimum standards, and must address topics such as portfolio differentiation, rating criteria, responsibilities of parties that rate borrowers and facilities, definition of what constitutes a rating exception, parties that have authority to approve exceptions, frequency of rating reviews, and management oversight of the rating process.

A bank must document the rationale for its choice of internal rating criteria and must be able to provide analyses demonstrating that rating criteria and procedures are likely to result in ratings that meaningfully differentiate risk.

Rating criteria and procedures must be periodically reviewed to determine whether they remain fully applicable to the current portfolio and to external conditions.

In addition, a bank must document a history of major changes in the risk rating process, and such documentation must support identification of changes made to the risk rating process subsequent to the last supervisory review.

The organisation of rating assignment, including the internal control structure, must also be documented.

419. Banks must document the specific definitions of default and loss used internally and demonstrate consistency with the reference definitions set out in paragraphs 452 to 460.

420. If the bank employs statistical models in the rating process, the bank must document their methodologies.

This material must:

• Provide a detailed outline of the theory, assumptions and/or mathematical and empirical basis of the assignment of estimates to grades, individual obligors, exposures, or pools, and the data source(s) used to estimate the model;

• Establish a rigorous statistical process (including out-of-time and out-of-sample performance tests) for validating the model; and

• Indicate any circumstances under which the model does not work effectively.

421. Use of a model obtained from a third-party vendor that claims proprietary technology is not a justification for exemption from documentation or any other of the requirements for internal rating systems.

The burden is on the model’s vendor and the bank to satisfy supervisors.

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